What is Due Diligence?

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Definition:

Due diligence is the process of investigating something, usually a potential investment or plan for the future, to ensure that you know all of the details and risks before making a commitment.

🤔 Understanding due diligence

When a business is deciding whether to expand into a new market or to acquire another company, there is a lot of legwork involved before the company actually starts the process. Before purchasing a competitor, the business will want to carefully examine every aspect of that competitor: its revenue and expenses, its debts, any potential future liabilities, and so on. Doing a thorough examination before moving forward is doing due diligence. Due diligence is also a legal term describing the requirement that a broker research potential pitfalls in any transaction for the person they are assisting with a sale before the transaction is completed.

Example

Suppose an investor decides that they want to buy shares in company XYZ. Before committing to the purchase, the investor researches company XYZ, looking at the business’s financial statements, listening to investor phone calls, and reading news articles about the business and its industry. This research is part of doing due diligence to decide whether the investment is a good idea.

Takeaway

Due diligence is like compiling research before writing a college paper…

When a student has to write a 20-page paper for a history class, the first thing they should do is gather research material: books, articles, and web pages related to the topic. These resources can help them write the paper and make sure that they include all of the relevant facts, increasing their chance of getting a good grade. In finance, due diligence involves gathering research to increase the odds of making the right financial decision.

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What is due diligence?

Due diligence is the process of doing a proper amount of research about a topic before making a decision. In the world of finance, due diligence means researching the details of a financial transaction before going through with the deal. This includes researching the hard facts and numbers behind a sale as well as the potential effects of the human elements involved.

Due diligence is also a legal concept. In some situations where a person acts on another’s behalf, they must perform due diligence before committing to a course of action. Failing to practice due diligence could result in legal trouble. For example, a stockbroker must do due diligence on the securities they sell to make sure they meet the investor’s goals.

What are examples of due diligence?

A person who wants to buy a home will typically conduct due diligence before signing a contract to purchase the home. Examples of the due diligence for a home buyer include getting a home inspector to look at the home, checking the home for lead paint, and getting the house appraised.

A business that wants to expand into a new market would complete due diligence before committing to the expansion. It may want to research competitors and future threats to consumer demand.

Lawyers perform due diligence when interviewing clients or witnesses. They must ask all questions that could uncover information relevant to the case, so that they are equipped with all the knowledge needed to assist their client.

A lender who receives an application for a loan performs due diligence before making a lending decision. They’ll want to consider the facts of the application, such as how much the person needs to borrow and the reason for borrowing money. They’ll also typically research the person who submitted the application, verifying their employment and income, and checking their credit history for defaults or late payments.

What is the due diligence process for stock investments?

Investors should go through a due diligence checklist before purchasing stocks to ensure that they know as much as possible about the company in which they are investing. Due diligence is a multi-step process and should continue even after the investor purchases a stock.

The first thing that an investor should do after selecting a potential company to invest in is look at the business’s financial statements. This includes things like balance sheets and income statements from the current and previous years. These statements can give investors a quick idea of a company’s performance. Is it making more money than it spends? Are its profit margins growing or shrinking? Answers to those questions are a good place to start when researching a business.

After reviewing a company’s financial situation, an investor should look at outside factors that could influence the business’s future. Are there many competitors, and are those competitors growing and shrinking? Is the industry that the potential investment operates in healthy, or is it performing poorly?

Potential investors also need to identify the risks that a company will face in the future. Is it currently in legal trouble and facing a court decision that could bring financial penalties? Could government regulation damage the business’s activities? Playing devil’s advocate about an investment is an important part of due diligence.

Investors who want to do further research before committing to their investment can look into things like a corporation’s management team and ownership. Is ownership concentrated in the hands of a few powerful investors or spread across many people? Do people on the management team have a track record of success?

What are some of the due diligence processes for buying a house?

When you’re buying real estate, due diligence is an important part of closing on the sale after you put in an offer but before you sign a purchase agreement.

The exact timing of the due diligence process varies with the location, but it usually falls between the seller accepting the buyer’s offer and finalizing the sale. The due diligence process gives the buyer a chance to research the home to make sure it appears as advertised. While many states require that sellers disclose known issues with a property, not every state does. Even if you reside in an area with mandatory disclosure, due diligence gives you an opportunity to uncover defects the current owner isn’t aware of.

One of the first things to do during the due diligence process is speak with your lender. Many lenders want to inspect the property before finalizing a loan. The bank may be able to uncover issues you wouldn’t. It’ll also save you from a surprise if the lender refuses to lend you money to buy a specific piece of real estate.

You should also speak to home insurance companies about the cost to insure a property you’re thinking about buying. Insurers can tell you if the property is in a high-risk area.

Researching the history of a piece of property and the neighborhood is also important. If the property has changed hands far more often than other properties in the area, that’s a red flag. Researching the neighborhood can also help you compare the value of the home you’re buying with similar homes and learn about how safe the area is, how good the local schools are, and what amenities are nearby.

Of course, due diligence includes physically inspecting the property. You should visit the property multiple times to get a sense of what it’s like during the day, at night, or on the weekends. It also gives you the chance to find quirks about the property or items of concern that would usually only be seen by occupants of the property. A professional property inspector can check for issues with the structures on the property, such as issues with the foundation.

Identifying these types of issues before finalizing a sale can save you a lot of headaches or force the seller to offer concessions, saving you money.

What is due diligence for a startup company?

For someone who wants to start a company, due diligence is an essential part of starting a successful venture. The due diligence process can help entrepreneurs identify business opportunities and markets where they can succeed.

The first step in doing due diligence before starting a company is assessing your own financial situation. Ask yourself questions like:

  • How much cash do I have available?
  • How much am I willing to invest in this business?
  • How much money does the business need to succeed?
  • How will I cover living expenses while working on this company?

Next, you’ll want to flesh out your idea for a new business. What industry will the company operate in? Is there a demand for the product you’ll sell? How can you best meet your customers' needs? How will you distribute your product?

Third, think about the risks of starting a new company and how to mitigate them. How will you manage inventory? Are you willing to make a second investment in the company if it has a cash shortfall? How will you handle the competition?

Following these steps helps entrepreneurs decide whether a specific venture is a good idea and equips them with information they can use when running their new company.

If you want to invest in a new company, the process is slightly different.

For investors buying shares in a new company, due diligence is similar to the due diligence for buying any stock. They need to look at the business, its revenue, expenses, assets, and liabilities to assess its profitability. The investor should also take time to think about the business’s opportunity for growth and potential threats.

The biggest difference when investing in a startup is that investors in startups tend to have more access to the management and founders of the business than investors in major companies. That makes meeting with and getting to know the stakeholders an important part of due diligence. Much of the success of a startup relies on the skills and knowledge of its founders, managers, and employees, so potential investors want to make sure they’re investing in a well-run business.

What are hard and soft due diligence?

There are different types of due diligence that people and businesses perform. When a business wants to expand by acquiring or merging with a competitor, it must perform both hard and soft due diligence to maximize the chances of success.

Hard due diligence looks at facts and concrete data — things like business revenues and expenses, debts, ongoing legal cases, and similar, quantifiable things. Hard due diligence can help a company decide whether a potential merger or acquisition makes sense financially and legally. This type of due diligence identifies potential legal issues with the target company and how the acquisition could impact the acquiring business’s revenue, cash flow, and other financials.

Soft due diligence looks at less quantifiable things, such as company culture and leadership. Two businesses in the same industry can have wildly different cultures. Trying to combine two different cultures adds a lot of complications to the process of merging businesses. An acquisition or merger may be more successful if both companies have similar cultures and leadership values.

Even if the merging companies have different cultures, doing soft due diligence and identifying this fact before starting the process is important. It can give both leadership teams a warning before culture clashes occur. Failure to do soft due diligence could cause difficulty during the merger as incompatible cultures push against each other, leaving employees confused about the values and goals of their employer.

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